Conditionality in Fund-Supported Programs—OverviewPrepared by the Policy Development and Review Department

February 20, 2001

I. Introduction

1. The Fund's conditionality has been an important element in recent
proposals to reform the international financial system. In particular,
the Managing Director's intention to focus and streamline conditionality
and give greater scope for national ownership—a central feature of
his vision for the institution—was welcomed by the International
Monetary and Financial Committee at its September 2000 meeting. The staff
have prepared a set of papers on conditionality as the basis for a discussion
by the Executive Board; their scope and coverage is set out in Appendix
to this paper. The present paper presents a brief overview of the issues:
section II reviews the expansion of conditionality over the past several
years, and section III discusses approaches to streamlining. Section IV
presents issues for discussion.

II. Experience with Conditionality

2. Conditionality—the link between the approval or continuation
of the Fund's financing and the implementation of specified elements
of economic policy by the country receiving this financing—is a
salient aspect of the Fund's involvement with its member countries.
This link arises from the fact that the Fund's financing and policy
adjustments by the country are intended to be two sides of a common
response to external imbalances. Conditionality is intended to ensure
that these two components are provided together: it provides safeguards
to the Fund to ensure that successive tranches of financing are delivered
only if key policies are on track, and assurances to the country that
it will continue to receive the Fund's financing provided that it continues
to implement the policies envisaged.

3. Conditionality has evolved substantially over the history of the
Fund. Some element of policy conditionality has been attached to Fund
financing since the mid-1950s, but the scope of conditionality has expanded,
particularly since the early 1980s. In the process, tensions arose between
the desire to cover aspects of policy central to program objectives
and the importance of minimizing intrusion into national decision-making
processes. Against this background, the 1979 Guidelines on Conditionality
underscored the principle of parsimony and the need to limit performance
criteria to the minimum number needed to evaluate policy implementation.
They also stressed that the Fund should pay due regard to the country's
social and political objectives, economic priorities, and circumstances.1

4. The period since the Guidelines—and especially the past decade—has
seen a major expansion of conditionality, particularly in the structural
area. While structural measures were rarely an element in Fund-supported
programs until the 1980s, by the 1990s almost all programs included
some element of structural conditionality. The expansion of structural
conditionality was also reflected in increasing numbers of performance
criteria, structural benchmarks, and prior actions (Figure
1).2

5. These changes were the result of several forces. First, the Fund
has over time placed increasing emphasis on economic growth as a policy
objective, with the recognition that raising growth on a sustainable
basis requires strengthening the supply side through structural reforms.
This emphasis is reflected in the 1974 Board decision to establish the
Extended Fund Facility (EFF) to address the situation of "an economy
experiencing serious payments imbalance relating to structural maladjustments...or
an economy characterized by slow growth and an inherently weak balance
of payments position which prevents pursuit of an active development
policy."3 Growth
became increasingly prominent as an objective in the 1980s, against
the background of the poor growth record of the heavily indebted countries
and mounting criticisms that Fund programs had focused excessively on
austerity.

6. Second, the Fund became increasingly involved with different groups
of countries in which structural reforms were viewed as a particularly
important part of an overall policy package (Figure
2). In particular, with the establishment of the Structural Adjustment
Facility (SAF) and later the Enhanced Structural Adjustment Facility
(ESAF) in the 1980s, the Fund became increasingly involved in lending
to low-income countries. The explicit purpose of these facilities was
"the alleviation of structural imbalances and rigidities"
in low-income developing countries, "many of which [had] suffered
for many years from low rates of economic growth and declining per capita
incomes."4

In addition, the Fund became extensively involved in assisting the transition economies after the breakdown of Communism in Europe in the early 1990s: in these countries too, major
structural reforms were at the heart of the economic agenda. In both
these groups of countries, both external adjustment and growth were
impeded by massive structural distortions, and it was believed—especially
in light of early experience—that attempting to transfer resources
to these countries without tackling these distortions would be largely
futile. Structural reforms were also important in the Asian crisis countries
for another reason: while these countries had achieved impressive growth,
serious financial sector vulnerabilities were at the root of their financial
crises, so reforms aimed at addressing these vulnerabilities were key
to the restoration of confidence on a sustainable basis.

7. A third factor behind the expansion of structural conditionality
was an increasing awareness that the monetary and fiscal policy objectives
that are key to macroeconomic adjustment often themselves depend critically
on structural conditions—including the removal of extensive market
distortions and the establishment of the institutional underpinnings
for effective policy making in a market economy. In many cases, this
awareness reflected bitter experience with macroeconomic policy adjustments
that failed to take root, or had adverse side effects, due to weak structural
underpinnings. As a related point, an increasing body of experience
began to suggest that fiscal sustainability depends on the composition
of fiscal adjustment, and more fundamentally on reforms to strengthen
revenue performance and remove various drains on the budget. The need
for structural reforms to underpin macroeconomic policies is partly
reflected in the fact that a large share of the Fund's conditionality
has been in the core areas of fiscal policy, the financial sector, and
the exchange and trade system, and that these areas account for much
of the increase in structural conditionality over the past decade (Figure
3). Other areas in which conditionality has expanded, public enterprise
reform and privatization and social security reform, also frequently
have important implications for fiscal sustainability.

8. This change in the policy content of programs has gone hand in hand
with a change in the modalities by which the Fund monitors policies.
The 1979 Conditionality Guidelines envisaged that program monitoring
would be mainly through performance criteria: a performance criterion
is a condition that must be met for the Fund's financing to continue,
unless the Board grants a waiver. The other main tool of conditionality,
program reviews, was seen mainly as an occasion to set performance criteria
beyond the first year of a program, and in rare cases to monitor policies
where uncertainties precluded the setting of performance criteria. In
recent years, however, program reviews have increased in importance
as an opportunity for both backward- and forward-looking assessments
of program implementation.

9. The increasing importance of reviews reflects, in part, greater
uncertainty about key macroeconomic relationships in a world of high
capital mobility; these circumstances exacerbate the difficulty of specifying
a path of performance criteria a year ahead.5
It also reflects the increasing role of structural reforms, which are
often difficult to characterize quantitatively or even qualitatively
with sufficient precision to be suitable as performance criteria. Moreover,
many key structural reforms take considerable time to implement, making
it important to find some way of tracking progress toward the ultimate
objective. This has been done in many cases by using a set of structural
benchmarks to map out a series of steps toward an overall policy result.
A structural benchmark is different from a performance criterion in
that failing to achieve it would not by itself interrupt the Fund's
financing. Performance relative to such benchmarks does, however, help
inform the Board's assessment of progress on structural reforms during
reviews and is bound, therefore, to influence the Board's decision on
whether to complete a review. The increasing role of structural benchmarks
is reflected in the fact that, behind the overall expansion of conditionality
is a proliferation of structural benchmarks, and to a lesser extent
of prior actions, compared with a much more modest increase in the number
of performance criteria (Figure 4).

10. Along with this shift in monitoring techniques has come an increasing
lack of clarity with regard to the boundaries of conditionality. Conditionality
is that part of the authorities' policy program that is being monitored
as the basis for decisions on the use of Fund resources: the defining
question is, "If it's not done, can that stop the Fund's financing?"
But in many cases, conditionality has been applied (or has been construed
as applying) to reforms that are not really critical to the Fund's decision
on whether to continue its financing. Moreover, a Letter of Intent (LOI)
is often used to lay out the authorities' entire policy program; and
in some cases, it even includes technical assistance advice and the
policy priorities of other international financial institutions, regardless
of whether the Fund has any intention to make these conditions for its
financing.

11. Such murkiness on the boundaries gives the misleading impression
that conditionality is all-encompassing. In some cases, this lack of
clarity may serve the purposes of the authorities, Fund staff, and/or
other international financial institutions, by lending the Fund's imprimatur
to elements of the policy agenda whether or not they are at the core
of the Fund's concerns; but this comes at the cost of hindering the
emergence of a healthy policy debate within the country and of understanding
of the role of each international institution in the country. The lack
of clarity of the boundaries also has implications for the application
of conditionality: in particular, unless the scope of program reviews
is precisely delineated, it may not be clear, even within the Fund,
which elements of the Letter of Intent can directly affect the completion
of a review.

12. Both the increasing structural content of Fund-supported programs
and the changing approach to program monitoring has taken place, at
least in part, for good reasons. Nevertheless, it has prompted legitimate
concerns: in particular, that the Fund is overstepping its mandate and
core area of expertise, using its financial leverage to promote an extensive
policy agenda and short-circuiting national decision-making processes.
Moreover, the expansion of conditionality raises issues regarding its
effectiveness. If conditionality is too comprehensive, it may undermine
the authorities' assurances of purchase, since it increases the chance
of failing to meet all conditions even when the policies that are critical
to program objectives are actually on track. A proliferation of measures
also has the potential to blur the Fund's focus on what is essential
to ensuring that the program fulfills its purposes.

13. Concerns have also been voiced about whether recent Fund-supported
programs have taken adequate account of the authorities' ability to
muster political support for a multitude of policy changes at one time,
as well as their capacity to implement these reforms. In some cases,
these concerns may simply point to a need to provide technical assistance
and/or elicit support from other international institutions, to guide
the implementation of policies that are needed for the program to succeed.
In other cases, however, conditionality may have been established on
policies that were unlikely to be delivered, calling into question the
realism of program design. In instances in which the minimum set of
policies required to make a program viable may be beyond the authorities'
political and administrative capacity to deliver, saying "no"
may be a better choice, albeit often a very difficult one.

14. Finally, there are concerns that overly pervasive conditionality
may detract from implementation of desirable policies by undermining
the authorities' ownership of the program. It is the authorities who
must implement policies, and it is mainly they and their citizens who
live with the consequences of either action or inaction. Policies are
not likely to be implemented in a sustainable way unless the authorities
accept them as their own and unless the policies command sufficiently
broad support within the country. Conditionality that is too pervasive
may galvanize domestic opposition to the program as well as blurring
the authorities' focus on what is essential. Experience suggests that
the link between conditionality and program ownership is a complex one;
in particular, there are cases in which high program ownership has gone
hand in hand with extensive conditionality, as a government wishes to
use a Fund program to strengthen its commitment to an ambitious set
of domestically-owned reforms. Nonetheless, the strong likelihood that
a more focused approach to conditionality will enhance country ownership
is an important motivation for streamlining.

III. Streamlining Conditionality

15. The issues highlighted in the previous section set the stage for
consideration of how to streamline the Fund's conditionality. Streamlining
requires:

reassessing the scope of conditionality—i.e. what policies
are to be covered by the Fund's conditionality—particularly in
the structural areas;

choosing the appropriate degree of detail of conditionality—i.e.
how these policies are to be monitored; and

clarifying the boundaries between what is covered by conditionality
and what is not, as well as between the Fund's conditionality and
that of other institutions.

16. There are two main approaches to curtailing the scope of structural
conditionality. First, a higher threshold of relevance could be applied
in deciding whether a particular policy action should be covered by
conditionality in a particular instance. The existing Guidelines on
Conditionality prescribe that performance criteria should be limited
to those needed to ensure the achievement of program objectives. In
principle, this is a stricter test than, for instance, the macroeconomic
relevance test applied in the context of surveillance.6
It can also be compared with the criterion established for the Fund's
involvement in governance issues—which is to be "guided by
an assessment of whether poor governance would have significant current
or potential impact on macroeconomic performance in the short and medium
term".7 But
in practice, the test of macroeconomic criticality has been applied
with considerable latitude. Accordingly, the Interim Guidance Note on
Streamlining Structural Conditionality stresses the need to limit conditionality
to those measures that are critical for the achievement of the program's
macroeconomic objectives. The intention in applying a relatively strict
criterion for the application of the Fund's conditionality is to change
the mindset with which the staff, management, and the Board consider
whether certain structural measures should be covered under conditionality,
shifting from a presumption of comprehensiveness to a presumption of
parsimony, and thus putting the burden of proof in each case on those
who would argue for the inclusion of additional measures under conditionality.

17. A second aspect of streamlining is establishing a better division
of labor with the World Bank and other involved multilateral and bilateral
institutions and agencies. In the past, the Fund's cooperation with
these institutions has not generally contributed to streamlining: on
the contrary, in many cases policy measures important to these institutions'
objectives have been included in the authorities' Letters of Intent
and sometimes established as structural benchmarks or even performance
criteria. Steps are now underway to establish a more efficient division
of labor. Under the Poverty Reduction Strategy Paper (PRSP) framework
for low-income countries supported by the Fund's Poverty Reduction and
Growth Facility (PRGF), the Fund and Bank work closely together to support
the implementation of a common country strategy and to focus their efforts
on their respective areas of responsibility. Under this framework, the
Fund will not normally establish conditionality outside its mandate
and expertise except where these are essential to the country's fiscal
and/or external targets. Instead, these structural and social areas
will be covered by complementary World Bank-supported programs. The
Bank's recent establishment of the Poverty Reduction Support Credit
(PRSC) will facilitate this demarcation of responsibilities, inter alia,
by better aligning the time-lines of the two institutions' financing.
No such framework yet exists for middle-income countries, but greater
efforts are being made to improve coordination between the Fund and
the Bank in these operations, including through upstream consultation
between the two staffs on emerging structural issues in individual programs.
Where the Fund's conditionality still needs to cover some measures outside
its core areas of competence, it is essential that the authorities receive
adequate advice (from the Bank or from other relevant institutions)
on how to implement the agreed measures.

18. Another important aspect of streamlining is with regard to the
degree of detail with which policies are monitored. Much of the proliferation
of conditionality reflects the practice of mapping out a series of steps
toward a particular policy outcome, in some instances using tools of
conditionality such as structural benchmarks, in others by listing the
individual steps in a policy matrix. For instance, in one case the introduction
of a value-added tax involved 19 structural benchmarks. In many cases,
the intention has been to help guide policy implementation or to clarify
the extent of progress that will be required in order to complete a
review. But this degree of detail of conditionality creates the perception
that the Fund is trying to micromanage the authorities' policy program,
hampering their flexibility in choosing a different yet viable road
to an agreed destination.

19. One solution to the perception of micromanagement would be to rely
to an increasing degree on results-based conditionality: making the
Fund's financing conditional on the achievement of specified outcomes—such
as bank recapitalization, or improved tax enforcement, or foreign exchange
market liberalization—rather than on the steps toward those outcomes.
The main argument for this approach is that it would give the authorities
greater flexibility in choosing the appropriate method of achieving
agreed objectives. If the steps taken by the authorities fail to lead
to the desired outcome, the program would need to be reassessed before
the Fund's financing would be made available. Such a strategy would
undermine the country's assurance of being able to draw on the Fund's
resources, but would make the authorities responsible for adapting policies
to changing circumstances to achieve the intended results. The Fund's
traditional macroeconomic conditionality is already somewhere on the
spectrum between actions- and results-based conditionality, as it involves
intermediate targets—such as ceilings on central bank credit to
government—whose outturns in practice reflect economic developments
as well as the actions taken by the authorities.

20. While results-based conditionality may have greater applicability
than at present, its main limitation is that many structural as well
as macroeconomic results take considerable time to achieve. For instance,
there are cases in which policy adjustments in a particular area are
essential to program objectives, but are not likely to come to fruition
until close to the end of the program or even later; in this instance,
ex post conditionality would not safeguard the Fund's resources
unless the Fund's financing were heavily back-loaded—which would
bring it out of line with the country's financing needs.8
This is the motivation for basing the Fund's financing on some assessment
of progress toward key policy objectives, in the context of a review.

21. This raises the issue of what guides the Fund's assessment of progress
in a review. Here, there are two main models: one is to establish a
series of structural benchmarks that are intended to inform the process
of assessing progress at the time of a review. An alternative is a more
free-form assessment, albeit based on considerations that should be
discussed with the authorities ex ante. The latter approach gives the
authorities greater flexibility in devising their own path toward an
objective that is agreed to be essential, while also giving the Fund
greater flexibility in deciding what information is relevant to its
assessment of progress; its main drawback is that it gives the authorities
less assurance of the conditions on which they will be able to use the
Fund's resources. While recognizing this tradeoff, it is worth considering
whether the current balance is the right one—or whether a more
sparing use of structural benchmarks would be desirable.

22. There are two further issues in the use of structural benchmarks.
First, even when an overall policy objective is critical to program
objectives, there are cases in which fewer benchmarks would suffice
to indicate the path that the authorities would be expected to follow:
each benchmark should pertain to a policy action that, while not decisive
in itself, is nonetheless a significant and representative step. Second,
there is a need for greater prioritization in the areas of policy covered
by structural benchmarks: conditionality should not be encumbered with
structural benchmarks in cases in which the overall outcome is not critical
to the program. Of course, the staff may offer useful advice in many
areas (perhaps in the context of technical assistance) while eschewing
any impression that the Fund's financing hinges on the authorities'
acting on this advice.

23. As noted earlier, the scope of program reviews has seen substantial
evolution since the 1979 Guidelines on Conditionality. It is particularly
important to clarify and delineate the boundaries of these reviews.
These reviews should be used for both backward- and forward-looking
assessments of policies in areas that are essential to program objectives.
But, there may be a need to adjust policies to achieve the objectives
agreed at the start, reviews should not become an opportunity to move
the goalposts. Moreover, it is important to clarify up front, to the
extent possible, the areas to be covered in reviews and the basis on
which policies will be assessed, otherwise reviews have the potential
to be catch-all assessments of policy implementation.

24. It is also important to clarify the role of the Letter of Intent.
An LOI is not a commitment to the Fund, but a statement of the policies
the authorities intend to implement. In many cases, the LOI presents
the full sweep of the authorities' policy program; in such cases, the
Fund's financing is conditional on only some of these policies. But
in many cases, there has been a blurring of the boundaries of the part
of the authorities' program covered by conditionality. While in some
cases this lack of clarity may have served the purposes of the authorities
and the Fund staff—for instance in presenting the program to the
public and the markets—it has contributed to a misleading impression
that conditionality is all-encompassing. A solution would be either
to limit the LOI to those policies that are being monitored by the Fund,
or ensure that LOIs include a section that delineates precisely which
aspects of the authorities' program actually constitute conditionality.
Moreover, it may be desirable simply to end the practice of including
detailed matrices of policy actions in LOIs; in most cases, the Fund's
financing hinges on only a small subset of the measures in such matrices.

25. These considerations should be carried forward in revising the
1979 Conditionality Guidelines. Some elements of the Guidelines—notably
the emphasis on limiting conditions to those needed to monitor policies
essential to program objectives—remain appropriate although, as
noted, they have not been observed. Other elements of the Guidelines—notably
the circumscribed role envisaged for program reviews—should be
revised to reflect the changing environment in which Fund-supported
programs are framed. It is proposed that, in light of Board discussion
of the present set of papers, as well as comments received from outside
the institution, the staff would return with a proposal for revising
the guidelines following the Spring meetings.

IV. Issues for Discussion

26. Directors may wish to focus their interventions on the following
issues.

Directors may wish to comment on the factors leading to the expansion
of conditionality over the past several years, highlighting any lessons
for current practice.

Do Directors agree that the application of conditionality needs
to be focused and streamlined to ensure that it is consistent with
its intended purpose?

The paper discussed two different dimensions of streamlining conditionality:
curtailing the scope of policies included under conditionality, and
reducing the level of detail with which such policies are characterized.
With respect to limiting the scope, the basic proposal would be to
focus exclusively on those policies that are critical to the main
macroeconomic objectives of the program, including external sustainability
and growth, rather than those that are merely relevant to those objectives.
Directors may wish to comment on whether this general approach is
appropriate: in particular, is the appropriate test of whether a measure
be included under conditionality that it be critical to a program's
macroeconomic objectives?

In the specific case of the PRGF, close coordination with the World
Bank permits an improved division of labor between the two institutions
that would enable each to limit conditionality to its core areas.
They may also wish to consider the circumstances under which the Fund's
conditionality would nonetheless apply to measures outside the Fund's
core areas of responsibility.

How much scope do Directors see for conditionality to focus more
on broad policy results rather than on the specific actions intended
to achieve those results?

Another proposal for reducing the degree of detail of conditionality
to use structural benchmarks more sparingly, limiting them to important
and representative steps toward critical structural objectives of
a program. Directors may wish to comment on this.

The paper notes that the role of reviews has evolved beyond that
envisaged in the 1979 Guidelines, to include forward-looking assessment
of macroeconomic policies, and an assessment of progress and prospects
on structural and institutional reforms, especially those requiring
sustained effort over a lengthy period of time. Do Directors see this
evolved role as broadly appropriate? Do they believe it would be useful
to specify ex ante, to the extent possible, the basis on which policy
should be assessed, and to establish that reviews are not to be used
to add major new objectives to the program?

What do Directors see as the appropriate role of the Letter of
Intent? The paper suggests that either the LOI should focus only on
the aspects of policy covered by the Fund's conditionality or, in
cases in which the authorities wish to use the LOI to lay out the
broad sweep of their policy program, the LOI should make it clear
which elements of this program are subject to this conditionality.
Do Directors support this suggestion?

A Guide to the Conditionality Papers

27. In addition to this overview, the staff have prepared three other
papers as background for the Board discussion of conditionality. The
first paper is entitled Conditionality in Fund-Supported Programs—Policy
Issues. It begins with a review of the principles of conditionality,
including the basic purposes of conditionality, the desirable properties
of any modalities for monitoring program implementation, the tools of
monitoring—performance criteria, reviews, prior actions, structural
benchmarks—and the relationship between conditionality and ownership.
It goes on to describe the expansion of conditionality over the past
decade and the reasons for this expansion. Then it discusses approaches
to streamlining conditionality and enhancing ownership: narrowing the
scope of structural conditionality, reducing the degree of detail, clarifying
the use of tools and the boundaries of conditionality, and other steps
to enhance ownership. Annexes review literature on the macroeconomic
outcomes of Fund-supported programs, the effectiveness of conditionality
and ownership, and various reform proposals including those that would
eliminate conditionality in its present form.

28. The second paper, Structural Conditionality in Fund-Supported
Programs, accounts for the expansion of structural conditionality
in recent years. This paper presents factual information on conditionality
drawn from the MONA database9
and a survey of a sample of mission teams, as well as a number of case
studies. It examines the coverage of structural conditions across different
areas of economic policies, and discusses the factors influencing the
expansion of conditionality, including the pattern of collaboration
with the World Bank and other institutions. It also examines the changes
in monitoring practices, including the shift to greater use of program
reviews and the proliferation of structural benchmarks and prior actions.
Finally, it discusses factors influencing the implementation of structural
reforms, noting that the data do not shown any significant relationship
between the number of conditions in a program and the fraction of these
conditions that are implemented.

29. The third paper, Trade Policy Conditionality in Fund-Supported
Programs, focuses on a particular area of policy to which conditionality
has been applied. It discusses first the role of trade policy in the
design of Fund-supported programs, and then goes on to document the
extent and focus of trade policy conditions, the way these conditions
are monitored, and the experience with their implementation.

30. In addition, the Executive Board recently discussed a paper, Review
of the Fund's Experience in Governance Issues, which sets out the
evolution of the Fund's recent work in this area, including in the context
of Fund-supported programs.

1
See Selected Decisions and Selected Documents of the International
Monetary Fund, Twenty-Fourth Issue, Washington DC, 1999, pages 137-139.2 In contrast, there
was virtually no change in the number of quantitative macroeconomic conditions
during this period.3 See Decision No.
4377-74/114, in Selected Decisions and Selected Documents of the International
Monetary Fund, Twenty-Fourth Issue, Washington DC 1999, pages 150-154.4The Chairman's
Summing Up at the Conclusion of the Discussion on the Structural Adjustment
Facility-Review of Experience, EBM/87/93,June 19, 1987 (BUFF/87/118).
5 For instance, in
the area of monetary policy, the Board agreed in January 2000 to authorize
an approach whereby program reviews would be used to assess whether monetary
policies remained on track to achieve an inflation target. See Inflation
Targeting-Implications for Conditionality (SM/99/296). 6 See Biennial
Review of the Implementation of the Fund's Surveillance Policy and of
the 1977 Surveillance Decision (SM/00/40), February 2000.7 See The Role
of the Fund in Governance Issues-Guidance Note, July 2, 1997. The
note indicates, however, that conditionality in this area should be limited
to "policy measures...that are required to meet the objectives of
the program". 8 The 2000 Review
of Fund Facilities found that, on the contrary, financing needs are if
anything more front-loaded than the usual schedule of uniform purchases
and repurchases.9 MONA is a database
recording policy conditions as well as macroeconomic assumptions for Fund
arrangements. Data are submitted by mission teams at the time of program
approval and at each program review. Data have been collected since 1993.